a result of externalities and distributional considerations (Flemming and Mayer, 1997). Taxation also drives a wedge into cost of capital calculations, with the private sector evaluating projects at an after-tax cost of capital, and the government at pre-tax costs (Brealey et al., 1997). Some of these issues are taken up again when we examine the question of the appropriate discount rate and the returns to PFI projects.
perspective, which aims to maximize service efficiencies in the ancillary services as well as aid maintainability and minimize life cycle costs, for exam- ple using better quality materials. Even small changes (e.g. allowing access space for ease of maintenance) have had a large cumulative effect. As Peter Drucker (1984) argues, innovation is often not about grand architectural design but about the cumulative impact of a large number of small changes.
Thus in one hospital project in the UK, the contractor was able to cut down on cleaning costs by having window sills at 45 degrees so that people could not put things on the sills and generate extra cleaning costs. In an Australian hospi- tal project, designing dedicated access space in the roof area and allowing access corridors enabled maintenance of the plant and machinery without having to close down ward space. These benefits can be lost in traditional procurement methods due to little or no integration between design, construc- tion and operation of the facility.
It is in this sense that the PPP model can be seen as an incentive contract since the private sector entity is encouraged to think beyond the bounds of the construction phase and build in features that will facilitate operations and maintenance. Despite the arguments considered earlier in this chapter of those who see possible benefits in an ‘unbundling’ by government of PPP contracts into separate design, construction, operations, and maintenance contracts, vesting the coordination in one private sector entity (or consortium) provides a better set of incentives and a clearer line of accountability.
Risk
The PPP programme has raised awareness of project risks in ways that public procurement has to date not been able to do. The result is that the identifica- tion, allocation and management of risks have grown to become an essential part of PPP processes. These processes are examined in Chapter 7.
Value for money is improved by the transfer of appropriate risk as the supplier is able to reduce either the probability that the risk will occur, the financial consequences if it does eventuate, or both. There comes a point, however, when this transfer becomes sub-optimal. If risks that, in fact, cannot be best managed by the private sector continue to be transferred to private bodies, value for money will decline since the premium demanded by the private sector will outweigh the benefit to the public procurer. Optimum, rather than maximum, risk transfer is the objective of the PPP arrangement.
Public Sector Comparator
Competition and risk allocation are pre-conditions but do not guarantee value for money. The possibility of achieving extra value for money by implement-
ing a PPP can be estimated with a twofold analysis. This analysis is conducted prior to the PPP implementation and comprises, first, the calculation of the benchmark cost of providing the specified service under traditional procure- ment and, second, a comparison of this benchmark cost with the cost of providing the specified service under a PPP scheme.
The benchmark cost of providing the specified service with traditional procurement is known as the public sector comparator (PSC). Policy Statement Number 2 of the UK Treasury Taskforce (1998) guidance material defines a ‘Comparator’ as ‘the benchmark established against which value for money is assessed’ (section 1.3.1) and the PSC as ‘a cost estimate based on the assumption that assets are acquired through conventional funding expenditure and that the procurer retains significant managerial responsibility and expo- sure to risk’ (section 1.3.2). In effect, the PSC is intended to reflect the full risk-adjusted cost to government of delivering the project through conven- tional government funding.
In the Partnerships Victoria (2003) Technical Note on the Public Sector Comparator, the PSC is defined as a ‘hypothetical risk-adjusted costing’, by the public sector as a supplier, to an output specification produced as part of a PPP procurement exercise (p. 6). Features of the PSC calculation are as follows: the results are expressed in net present value terms; estimates are based on the outputs specified for the PPP procurement; they utilize the most recent actual method of providing that output (e.g. a traditional form of contracting such as design and build) including any reasonably foreseeable efficiencies the public sector could make; and the calculations take full account of risks that could be encountered. Nevertheless, the PSC remains a hypothetical estimate, not an actual cost to government.
Figure 6.1 illustrates the value-for-money comparison between a PSC and a PPP bid. Assuming all things equal (i.e. quality and risk allocation), value for money is demonstrated when the total present value cost of private sector supply is less than the net present value of the base cost of the service, adjusted for: the cost of risks to be retained by the government; cost adjustments for transferable risks; and competitive neutrality effects.
• Base or raw cost is the cost of providing the services required by the public sector. This is the public sector’s estimate of what it would have to spend to build and maintain the infrastructure and provide the asso- ciated services over its expected useful life in accordance with the performance specification.
• Retained risks are those which, by their nature, always rest with the public sector. The cost of retained risks is usually identical for the PSC and the private supplier. Retained risks are normally those involving changes to the enabling laws or regulations and the demand risk for the
services where there is no direct charge to the public (for instance long- term demographic changes).
• Risk adjustments are made for transferable risks that reflect the proba- bility that services may not be delivered at the cost shown in the base cost projection because of events like cost overruns or technical prob- lems, or that budgets may be maintained, but only at the expense of reductions in service quality.
• Competitive neutrality adjustments reflect that the PSC should be competitively neutral with the private sector proposal. Competitive neutrality ensures that the analysis of private sector bids does not lead to preference by reason only of redistributive mechanisms or other policy arrangements affecting either the private or public sectors.
Consequently, where applicable, the PSC should incorporate those state and local government taxes, levies or charges that may be payable by the private sector, as well as the cost of insurance that the public sector would otherwise set up through captive insurance arrangements.